Bottom Shekel / Banks Have Inside Information and You Have Nada

"The banks' core business is based on inside information." This time banks can't accuse a hostile press of spreading tall tales. This time it is an illustrious committee made up of experts, tasked with fulfilling an important duty, that is telling tales about them. This particular statement was made by the Hodak Commission, which was appointed by the Finance Ministry's insurance commissioner to investigate the way institutional investors invest in corporate bonds.

So now it's official: Institutional investors - that is, you with your pension money - may compete with the banks for corporate credit business. But the game is fixed. You and your pension savings have no real chance in the competition with banks.

When it comes to lending, banks have an understandable advantage, and you can only be thankful for the fact that you're allowed to scrape the bottom of the credit market barrel by buying bonds on the bond market.

There are two primary explanations for this. One is that banks enjoy unequal and unfair benefits (see "inside information"). The other is that banks generally use their own money to issue loans, so they care about them. Institutional lenders, on the other hand, use your money to issue loans - including your pension money - so they can be indifferent to the quality of loans they issue through buying bonds.

Sound shocking? It is indeed. The Hodak Commission investigated and found that banks have four crushing advantages over you and your pension savings in the credit market game.

A number of the advantages are simply incomparable. Banks naturally enjoy the benefit of "inside information." Banks extend loans to companies that they have conducted credit business with for years. Since the loans usually involve companies that also hold business accounts at the very same bank, the bank has real-time information on the company's revenues and expenditures and is able to assess its financial standing.

It goes without saying that your pension savings, managed by institutions prohibited from using inside information, will never enjoy the same intimate relations with their investors.

The means to pressure

And as if a steady stream of inside information were not enough of an advantage, banks also have the means to pressure debtors continuously. The local banking system is comprised of only a very limited number of banks, therefore companies are very careful to show banks due respect. The public's pension savings, on the other hand, are divided among hundreds of institutions, so that no single institution generates the same sense of trepidation that banks do.

Of course, this dread is well founded in light of the fact that the lending bank usually manages the company's bank accounts as well. The slightest delay in repaying a bank loan will immediately place a company at risk of bouncing checks. This threat is within the banks' power. Institutional investors, on the other hand (that means you), do not have the power to pose a threat to companies. Even if you threaten to boycott the next bond issue, it's a hollow threat, as there are hundreds of other institutional investors in the market.

Compounding the inherent advantages enjoyed by the banks are the relative disadvantages for institutional investors - again, that would be you.

Banks cannot spread the loans they issue to companies; they usually extend loans, on an individual basis, to companies they have a longstanding credit history with. A bank can't hold just part of a loan, as institutional investors do when they buy a small amount of corporate bonds; a bank also can't get rid of a loan by trading it on the open market, as bonds are traded. In other words, banks have a clear, long-term, vested interest in the loans they issue.

Moreover, a loan issued by a bank, particularly a business loan to a large corporation, can effect the bank's profits, and even its stability. A bad loan means damage to the bank's equity capital, and no bank wants to risk this. As a result, banks have a vested interest in making sure loans are good before they are even issued. Therefore, before every loan issue, they investigate thoroughly.

"Extension of credit is not the primary business of an institutional investor, which benefits from defrayal of the debt only indirectly, by charging fees for management of assets," the Hodak Commission writes. "Moreover, issuing of credit is one investment avenue out of a number available to institutional investors. As a result, the failure of a particular debtor to defray a debt should not have a significant effect on the managed assets."

In case you didn't understand, the Hodak Commission is telling you that an institutional investor, unlike a bank, has no vested interest in the loans it issues. The average loan (holding in a particular corporate bond) is small compared to the institutional investor's total investment, so there is no point in them making unnecessary inquiries into it. In any case, there is no point in making any effort: the loss inflicted by a bad loan is not the institutional investor's loss - it's yours, and that of your pension savings. The institutional investor will only lose the relative portion of its management fee, following a slight decline in the value of its managed assets. That's it. There is no real motivation for them to ensure that your pension savings are well invested.